Declining net profit margins. Extremely clear margin erosion can be seen each fy since fy 2002. Is this not a concern?

Incredible deterioration seen in PriceWorth's balance sheet. Company's nett debt is increasing each single year at an alarming rate.

Let's see.

Point 1.

Declining net profit margins. Extremely clear margin erosion can be seen each fy since fy 2002. Is this not a concern?

Its net profit margins came in at 4.6%.

Would this not be a worry considering the fact that this is a GRAND YEAR for the timber sector? Reasoning is if during a GRAND YEAR margins do not improve, what happens next when the good times or economic conditions turn poor or bad for the sector?

Point 2.

Incredible deterioration seen in PriceWorth's balance sheet. Company's nett debt is increasing each single year at an alarming rate

Here's an excerpt of a write-up from KN on Tekala, another company in the timber sector.

2. Sector Outlook

Our previous Update Report dated 11 May 2007 had sounded caution about the prospect of plywood prices (in USD), which appears to have been adversely affected by the slow down of housing starts and built up of plywood inventories in Japan.

We suspect that the timber sector’s down cycle may have just begun. Weakening prices could lead to sharp earnings contraction for most timber companies, and Teka la will not be spared. We are downgrading our FY08 revenue and net profit estimates to RM139.1m (-20.1%) and RM13.1m (- 41.8%), respectively.

Following the earnings downgrade, we are downgrading Tekala from a HOLD to a SELL with a 12-month target price of RM0.70 (-33.3% from RM1.05), which is based on a FY08 P/E of 8x – a slight premium to the 5.0x – 7.5x P/E-range for its timber peers in view of its exposure to the “hot” oil and gas sector.

Below expectation. IJMP’s annualised 1QFY08 earnings of RM12.6m was 58.8% below our full year forecast of RM121.2m and 54.3% consensus estimate. We are nevertheless expecting strong numbers in the subsequent 3 quarters to make up the shortfall. We are happy with the strong improvement in IJMP’s 1Q earnings, which jumped by 40.3% q-o-q and up by 137.5% from the same quarter last year on sharply higher CPO prices coupled with production growth.

This very statement caught my attention.IJMP’s annualised 1QFY08 earnings of RM12.6m was 58.8% below our full year forecast of RM121.2m and 54.3% consensus estimate.

OSK earnings forecast for IJMP's this fiscal year is a whopping 121 million!

Last fiscal year IJMP only managed a net earnings of 43.9 million.

Don't you think that this earnings forecast is simply too optmistic? And more so, considering that IJMP only managed a very impressive earnings of 12 million for its first quarter of its fiscal year 2008.

I had a chance to look at NetResearch write-up on Cymao and I found the section under earnings outlook rather interesting.

This is what they had to say.

Earnings Outlook

· Management expects demand from major export markets to remain weak whilst competition is likely to increase in view of the shrinking market size, leading to greater pricing pressure.

· As a result, management has indicated in the 2Q07 results announcement that it is highly probable that the company may not be profitable in 2007, contrary to earlier expectations.

· Cymao’s immediate plans are to commence logging operations in Sabah once the government gives the go-ahead to commence logging activities. The logging venture in Papua New Guinea is facing some delay due to the local elections.

· Although the immediate outlook for Cymao appears difficult, we believe longer-term fundamentals for the company remain intact due to the following:

o The still-firm log prices will eventually push up plywood prices as plywood makers look to recover the higher costs. These plywood makers would include the big Chinese operators which are currently importing logs mostly from Russia;o The inventory build-up situation in the US will eventually wind down;o The company’s new logging operations in Sabah and Papua New Guinea will reduce Cymao’s reliance on third party log supplies and cushion the volatility in log supply and log costs for the company.

Well, I only have one issue on the US market. Yes, the inventory situation WILL correct itself and the issue of high inventory build up cannot last forever. However, on the other hand, some serious consideration is due on the US housing market. A lame US housing market should probably do no wonders to such plywood players (plywood exporters to US market).

KUALA LUMPUR (Dow Jones)--IJM Corp. Bhd (3336.KU) Wednesday posted a net loss in the first quarter ended June 30 due to a one-off impairment expense of MYR922.3 million.

The diversified infrastructure and construction company had a net loss of MYR746.9 million, turning from a net profit of MYR54.3 million a year earlier.

The expense represents a goodwill payment made for its Road Builder Holdings Bhd. purchase in the quarter.

First-quarter revenue more than doubled to MYR1.11 billion from MYR518.0 million a year earlier, due to greater construction and infrastructure revenue from Road Builder as well as higher income from its plantations unit.

For the current financial year ending March 31, 2008, IJM said it expects its prospects to be "further buoyed by additional revenue and profit sources" from Road Builder's tolling and port operations.

It added that it expects to "record better operating performance for the current financial year" from construction project opportunities opened up by the implementation of the Ninth Malaysia Plan, a national blue print for development.

It explains that IJM posted the loss due to the one-off impairment expense.

Now take a look at this Business Times Article.

IJM operational profit soars

August 30 2007

BUILDER IJM Corp Bhd's first-quarter operational profit jumped more than 2.5 times as it booked earnings from the Road Builder group, a smaller rival that it recently bought.Do

In October 2006, IJM launched the biggest takeover bid in Malaysia's construction history by offering to buy all of Road Builder (M) Holdings Bhd's assets and liabilities for RM1.56 billion. By April 2, IJM completed the acquisition.

However, IJM's bottom line shows a net loss of RM747 million for the quarter to June 30. This is because it had to account for goodwill, the excess amount paid over an asset's value, in the Road Builder deal.

"We have to be prudent. Investors can be assured that this merger goodwill is a one-off accounting issue, it is a book entry. It does not, in any way, affect the group's future earnings or operational strengths," he told Business Times in an interview yesterday.

Buoyed by healthy number of projects booked in its orderbook and favourable palm oil prices, IJM's first-quarter operational profits jumped to RM228.34 million.

The group's infrastructure division marked significant improvement when it received maiden profit contributions from Road Builder's New Pantai Expressway, Besraya and port concessions.

Firstly, it was nice to hear that IJM boss wants to be prudent, ""We have to be prudent. Investors can be assured that this merger goodwill is a one-off accounting issue, it is a book entry. It does not, in any way, affect the group's future earnings or operational strengths"

However, IJM's bottom line shows a net loss of RM747 million for the quarter to June 30. This is because it had to account for goodwill, the excess amount paid over an asset's value, in the Road Builder deal.

This goodwill or the excess amount paid over an asset's value of 922.3 million, isn't this amount staggering?

Current cash balances is now at 65.317 million (versus 60.820 million the previous quarter)

Here is the breakdown of its cash balances.

Short term investments.. 24,372Short term deposits......... 39,162Cash and bank balances.. 1,783

Short term investment equates to total investments in marketable securities as at 30 June 2007. And as per it's earnings notes, this investment had carried a market value of 30.040 million. ( Company noted a gain of 2.1 million from disposal of securities)

Two things. One on hand, it's sitting on a nice gain. On the other hand, however, marketable securities can go down very fast! Would this be an issue?

Debts. No debts for Pintaras.

Dividends. Board has proposed at 10% less tax dividend. Improvement.

Company notes:

For the twelve months ended 30 June 2007, the Group's revenue increased by 53% to RM147.44 million from RM96.46 million in the preceding year, while profit before taxation grew by 119% to RM31.15 million from RM14.20 million for the respective period. The significant improvement in these results is mainly due to higher contribution by the construction and manufacturing divisions as well as an improvement in the performance of quoted investments over the preceding comparative year.

The Board is confident about the performance of the Group in the financial year 2008. This is in view of the existing strong order book, the numerous tenders submitted and the anticipated implementation of more construction projects under the Ninth Malaysia Plan. The Board expects that the Group's financial performance for the financial year 2008 to be good.

• The particleboard manufacturer reported 1H revenue and net loss of MYR173.0 mln (-9% YoY) and MYR6.1 mln (reversed from a net profit of MYR2.6 mln), respectively. While the top-line figure accounted for 39% of our full-year forecast, the loss was worse than expected.(company went from a net profit from 2.6 million to a net loss of 6.1 million!)

• The fall in revenue was attributable to a plant shutdown for maintenance services (about two weeks), while higher raw material costs (resin and rubber log), and interest and depreciation expenses depressed the profit margin. The plant utilization rate averaged 65% in 2Q07, lower than the 70% in 1Q07 but in line with our projection. ( Plant shutdown. Why? Higher raw material cost. With the high crude oil prices, this same cost issue persist! And as long as cost stays high, the it's simply gonna be difficult to make money!)

• Net gearing increased to 0.66x in 2Q07 from 0.57x in 2Q06. We expect net gearing to remain relatively high throughout 2007 given the limited cash flow from operations.( Net gearing increased! Limited cash flow? Doesn't this indicate clear deterioration in the company balance sheet? )

• From our channel checks, the average selling price (ASP) of particleboard has softened in 2Q07. We are cutting down our 2007 and 2008 ASP assumptions to US$130/meter cube and US$140/meter cube from US$145/meter cube, respectively. ( More problems! Average selling price soften! Look at it, higher cost and lower selling price! Hey, isn't this a recipe for tough times ahead! )

• In addition, we have lowered our projected gross profit margin by 1%-5% in 2007 and 2008, which brought down our profit forecasts to MYR4.3 mln (from MYR19.1 mln) and MYR30.1 mln (from MYR32.5 mln), respectively. ( WOW! They have lowered their net profit forecast from 19.1 million to 4,3 million!!! )

• We are upgrading our recommendation to Strong Buy fron Buy with a lower 12-month target price of MYR1.17 (from MYR1.26). Our target price is derived from ascribing a PER of 8x (no change) to Mieco’s projected 2008 basic EPS. ( Huh??? How on earth did this Strong Buy recommendation is derived from? )

• Our 8x target PER is at the lower end of Mieco’s four-year historical PER range of 7x-19x to account for its unfavorable near-term earnings outlook that will constrain valuation enhancement. However, Mieco is trading at 0.5x P/B, which we find undemanding from an historical and relative perspective.

•It is clear now that 2007 will not be a turnaround year for Mieco but we remain positive on the longer-term prospect of the company. We believe the producers will have more room for price increases once the new supply capacity is absorbed, hopefully by 2008. The high operating leverage will magnify its bottom-line once the ASP recovers, in our view. The underlying demand for particleboard as a cheaper and more environmentally sustainable substitute remains favorable.

• Risks to our recommendation and target price include unexpected aggressive capacity expansion by existing or new players that could prevent particleboard prices from moving upwards. Escalating crude oil prices could also adversely affect Mieco’s production costs, in our view.

How?

You see that the writer recognise that 2007 will NOT be a turnaround for Mieco. And as it is, they are only guessing that perhaps things could turnaround in 2008/

The purple fonts represented its incredible earnings projections. Point was, Crest Builder was touted and promoted to the investing community based on that 41.3 million earnings projections. (Here's an incredible footnote. Despite Crest Builder decent performance, Crest Builder earnings at this moment of time still could not reach that 41.3 million!)

And then my second posting was Ze Numbers Game: II, posted on Aug 21st 2006. Earnings looked decent but it's performance was simply no way close to what OSK had touted. (ps. did you see that OSK had a whopping TP of rm 2.59 then? LOL! Yes rm2.59! And the highest Crest Builder ever did was high of over 1.45 back in July 2007!)

If the company (Crest Builder) is doing well, then one should see some wealth generation in its balance sheet, right?

As of the earnings reported last night, Crest Builder had some 28.837 million in its piggy bank, trade receivables 100.788 million, total loans 153.567 million (a net debt of 124.680 million!). Half year net earnings is 15.797 million.

Monday, August 27, 2007

So when I received a copy of OSK research report on Cymao, I was rather interested to read what they said on Cymao.

The following is the excerpt from their notes.

Earnings will be bad this year

2Q07 results were disappointed. A loss of RM5.7m was incurred, mainly due to: (i) 35% lower y-o-y shipment volume; (ii) 7% drop y-o-y in plywood prices (iii) margin squeeze from 19% higher average log costs. In our sector report dated 17th Jul, we already highlighted the downside risk that smaller Sabah based timber manufacturers will face due to the housing market recession in the US and margin pressure because of heightening log costs. As Cymao has an exposure of 65% to the US market, we cut the company’s FY07 net profit by 86% and expect a recovery in FY08 when its logging activities in PNG and Sabah come on stream in 4Q this year. While we maintain a Neutral call, our fair value for Cymao is revised down to RM1.30 based on FY08 7x PE.

Below. Cymao’s 2Q07 net profit came in below our expectation. Compared to the preceding quarter, although volume has increased by 17%, selling prices continued to fall by 13%. Despite flat log cost q-o-q, the net impact was neutral. Adding to the disappointment, no DPS was declared for the quarter vs a 5sen tax free DPS in the same period last year.

Rising log costs squeezing margins. The continuous strengthening of log prices has negatively affected Cymao, which is not a timber concession holder. Margin for its plywood manufacturing this year is weakening when log cost is rising. Due to the delay in the issuance of log harvesting licence by the local authorities in PNG and Sandakan, Cymao is unable to capitalize on its own log resources to mitigate the negative impact.

Expect a better FY08. We nevertheless expect an earnings recovery in FY08 when the high-yielding logs trading come on stream in Oct/Nov this year. A large % of raw logs are likely to be exported to China as the management sees strong demand and the company has established business relationship with the local buyers. The absence of logs export quota in Sabah will allow Cymao to maximise its logs felling capacity.

Maintain Neutral with FY08 TP at RM1.30.We slash our FY07 earnings forecasts by 86% as the US housing market depression is likely to persist in the remaining of the year.

We maintain our Neutral call with a fair value of RM1.30 based on a PE of 7x for small cap timber players.

Ses, I do not understand it. They understand that earnings will be bad and they acknowledge the fact that the US housing market depression will have an impact on Cymao.

And incredibly, they had slashed their FY 2007 earnings by a whopping 86%!

WOW!!

So, if they can slash their earnings by 87%, from 15.3 million to a mere 2.1 million, does Cymao deserves a HOLD recommendation with a TP of 1.30??

Sales volume suffered as a result of demand from US has slown down significantly due to overstocking of plywood and drop in the construction activities.

The dumping of plywood products by China into Middle East and South Korea has affected the order book of the Group.

In addition, selling price has fallen by 7% compared to previous year corresponding quarter coupled with higher average log cost bu 19% has further damped the current quarter results registered with a negative gross margin.

Cymao loss 5.7 million for the quarter. On a q-q basis massive concern cos the last 3 quarters earnings went from a profit of 9.665 mil to 2.464 million to a net loss of 5.7 million.

The same period a year ago, Cymao earned 6.15 million

3. Cash Balances.

Cash balances dropped to 6.729 million.

4. Borrowings.

Total debts increased to 47.341 million.

5. Nett Cash.

Cymao is now in a nett debt of 40.621 million. Huge worry because if you look at the quarterly earnings table above, back in 2005 Q1, Cymao showed a nett cash position of 9.376 million. Company's balance sheet has certainly deteriorated for the worse!

Saturday, August 25, 2007

Take an investment grade share. The share price tumbles. Does this equate to an investment opportunity? Without a shadow of doubt that whenever a share displays some weakness in their fundamentals, which in returns causes its share price to fall, it does provides the investor with an opportunity... but in the case of investment, this (opportunity) should be examined in great detail because this investment is only deemed valid provided if the weakness or subdued financial performance is only a temporary situation. Well, if the subdued performance should drag on or continue for a longer time, this would then render the stock unattractive as the temporary weakness had caused a serious deterioration in the company’s fundamentals.

Remember, what used to be good might not be good in the future!

Yes, Mieco used to be an investment grade stock.

It was a stock which had a very impressive balance sheet, net cash and no debts (at it’s peak it had a net cash of 180+ million and no debts) and it had a pretty decent net profit margins.

The first chart of Mieco showed the 3 year chart of Mieco. It used to trade around the low 1.00 region. As the market rose during 2000 to 2004, Mieco’s investors were rewarded handsomely with the stock peaking around the 3.00 mark.... http://whereiszemoola.blogspot.com/2005/10/mieco.html

Group revenue decreased from RM86.1 million to RM78.0 million in the quarter under review due to lower selling prices and sales volume of particleboard and related products.

The Group registered a loss before tax of RM7.7 million against profit before tax of RM4.5 million in the corresponding quarter under review due mainly to lower sales, increased raw material cost and production stoppage for plant preventive servicing and maintenance.

For me, Mieco is another great investing learning example.

What used to be good, might not be good in the future.

Overly ambitious capital expenditure is a reason for concern.

No matter who and no matter how good the person giving the recommendation, following buy recommendation(s) never guarantees one success!

Thursday, August 23, 2007

Have a look at this table which shows its quarterly earnings since listing.

There is a drastic drop in earnings and there was drastic erosion in its earnings margins.

The company explained in its earnings notes.

COMPARISON WITH PRECEDING QUARTER'S RESULTS

The Group recorded lower revenue of RM22.23 million in the quarter under review (“Q3 2007”) as compared to RM28.28 million achieved in the previous quarter (“Q2 2007”). PBT decreased from RM10.01 million in Q2 2007 to RM2.23 million in Q3 2007. PBT margin also decreased from 35.4% in Q2 2007 to 10.0% in Q3 2007.

The comparatively weaker performance in Q3 2007 was mainly attributed to the following:

(a)Lower contribution from the camera components business segment due to significantly lower sales orders from the major SLR camera manufacturers. The poor performance of the camera segment was mainly attributed to high camera inventory levels experienced by the industry, which generally is the norm as seasonally the camera market tends to be soft during this time of the year.

(b)The HDD segment was also adversely affected by increased competition, resulting in its margins being squeezed coupled with lower volume orders from some of its major customers.

(c)Impact of the strengthening Ringgit (RM) against the US Dollar (USD), particularly, for export orientated companies. Consequently, the Group suffered foreign exchange losses which arose from the difference in book RM/USD rate compared to the realized RM/USD rate.

Tuesday, August 21, 2007

Aug. 20 (Bloomberg) -- The U.S. Federal Reserve's cut of the interest rate it charges banks was ``not justified'' and will create more problems, investor Marc Faber said.

In an effort to restore confidence in the wake of a credit crunch sparked by U.S. subprime mortgage losses, the Fed reduced the discount rate to 5.75 percent from 6.25 percent on Aug. 17. That was the first cut between scheduled meetings since 2001.

``I think it's an intervention into the marketplace that is not justified,'' said Faber, in an interview from Danang, Vietnam today. Injecting more money into the system will ``create an additional set of problems at a later date.''

Faber, founder and managing director of Hong Kong-based investment advisory company Marc Faber Ltd., correctly predicted the U.S. stock market crash in 1987. He also advised investors to buy gold in 2001, which has since more than doubled.

Global stock markets rallied as the Fed's move eased concern a rout in the U.S. mortgage market will spread and dry up access to capital. The global equities sell-off had erased more than $5.5 trillion of market value from a July 23 peak, according to data compiled by Bloomberg.

Asian stocks jumped the most in a year today, while U.S. shares posted their biggest gain in four years on Aug. 17 and Europe's Dow Jones Stoxx 600 Index was up 2.4 percent within 15 minutes of the Fed's announcement that it was taking action.

`Prepared to Act'

``The rate cut was pretty effective in curtailing panic in the markets which have no direct link to the subprime loan problem,'' said Masayuki Kubota, who helps oversee $2.1 billion in assets at Daiwa SB Investments Ltd. in Tokyo. ``Global growth won't be hampered by the subprime issue.''

The Fed left its benchmark fund rate target for overnight loans between banks unchanged at 5.25 percent.

In the statement, the Fed committee said it is ``prepared to act as needed to mitigate the adverse effects on the economy arising from disruptions in financial markets.'' Policy makers, who last held a scheduled meeting on Aug. 7, convene on Sept. 18.

Should the Standard and Poor's 500 Index drop below 1,400 the Fed is likely to reduce the overnight lending rate, Faber said. If the S&P rises above 1,500 it won't cut the rate, he said. The S&P 500 climbed 2.5 percent to 1,445.94 on Aug. 17. Still, it's down 6.9 percent from a record close set on July 19.

S&P 500 futures expiring in September rose 4.6 to 1,454.5 as of 11:42 a.m. in London.

No Dollar Collapse

``They're driven by asset markets, their policies, which is a mistake in the first place,'' said Faber, publisher of the monthly newsletter the Gloom, Boom & Doom Report. The housing problems arose in the first place ``because of easy monetary policies.''

Faber said that the dollar isn't likely to ``collapse'' as money flows to U.S. currency and yen assets.

``I believe that U.S assets, while they will not make a new high, they will outperform assets in emerging markets for a while,'' he said. ``There's a capital outflow from emerging markets into the U.S. and into the yen.''

“We've accounted today for $2-billion of the $35-billion. . . I think it would be fair to find out where the other $33-billion is being held.”

The short-term paper, sold as a good place to park cash at a premium return, has run into a major liquidity crisis in the current global credit squeeze, especially a variety sold by so-called third-party, or non-bank issuers, which currently accounts for about $35-billion of the approximately $120-billion Canadian ABCP market.

Monday, August 20, 2007

What Citigroup's Chuck Prince, the Fed's Ben Bernanke, Treasury Secretary Hank Paulson, and a host of other sophisticates should have known is that the bond and stock market problem is the same one puzzle players confront during a game of "Where's Waldo?" -- Waldo in this case being the bad loans and defaulting subprime paper of the U.S. mortgage market.

While market analysts can estimate how many Waldos might actually show their faces over the next few years -- $100 billion to $200 billion worth is a reasonable estimate -- no one really knows where they are hidden.

First believed to be confined to Bear Stearns's hedge funds and their proxies, Waldos have been popping up with regularity in seemingly staid institutions such as German and French banks, and that has necessitated state-sanctioned bailouts reminiscent of the Long-Term Capital Management crisis of 1998.

IKB, a German bank, and BNP Paribas, its French counterpart, encountered subprime meltdowns on either their own balance sheets or investment funds sponsored by them. Their combined assets total billions, although their Waldos are yet to be computed or even found.

So how now Brown Cow? Just how bad is it?

If one does not know how bad is it, how does one manage the current market risk?

Bill Gross continues..

Those looking for clues to the extent of the spreading fungus should understand that there really is no comprehensive data to allow anyone to know how many subprimes actually rest in individual institutional portfolios.

Regulators have been absent from the game, and information release has been left in the hands of individual institutions, some of which have compounded the uncertainty with comments about volatile market conditions unequaled during the lifetime of their careers.

Also many institutions, including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Default exposure, therefore, can hibernate for many months before its true value is revealed to investors and, importantly, to other lenders.

The significance of proper disclosure is, in effect, the key to the current crisis.

You cannot explain the problems with just one or two items. A perfect storm of this sort takes a number of factors all coming together to work its mischief. Bad mortgage underwriting practices, bad rating agency practices, a destruction of confidence, excessive leverage and then the withdrawal of that leverage, the need for yield, greed, and complacency which then in a Minsky moment (explained below) becomes paralyzing fear - all play their part....

Investors with long-term money should take the opportunity to buy into stocks that had been sold down significantly, he said.

“The price fluctuation does not matter as longas investors are buying into companies with good fundamentals and holding them on a long-term basis,” Lim said, adding that for prudence, investors could also buy in stages.

He is still optimistic on the oil and gas sector given its prominence in Malaysia as well as the domestic sector amid huge government spending on infrastructure development.

“The market can over-react on the upside as well as on the downside. Investors should stay calm and be aware of what is being said of the subprime concern. It can spiral into a major issue or it can also be contained,” he said, noting that a lot of hedge funds were affected, which was the reason behind the recent heavy selling.

Just thinking out loud now.

Firstly, I do believe that one should not abuse the reasoning of investing for the long term.

1. Say you invest in a business and you would dearly love to stay invested in the business for as long as possible, ie long term. However, life is never as prefect. What if during the course of our intended long term holding, the business fails for one reason or another? To continue and hold on to the failing investment for the sake of long term would most likely yield a less than satisfactory result.

2. Does price fluctuation matters?

This is where it gets tricky and I do feel that it is extremely hazardous for the the average investor. If one is an average investor, one needs to realistic enough to realise that one is just a normal average person. And sometimes, extreme price fluctuation can play extreme mind games to the average person.

Say one's buy a so-called good fundamental stock before this mess happened. At this moment of time, some of these so-called good fundamental stock has fallen some 50% due to the current price fluctuation. So let me ask this now, how now Brown Cow? Could one stomach this price fluctuation? If no, isn't understandable for one to eliminate their risk from further price fluctuation by cashing out of their investment? Hey, they are protecting their capital, yes? And protection of capital, isn't it paramount?

So in my opinion, price fluctuations cannot be discounted. We are but normal human beings. And when extreme price fluctuation happens, trust me, it does matter!

Sunday, August 19, 2007

A couple of months ago, back in 7th May 2007, I blogged on the following posting: It's Bubble Everywhere. Mr. Grantham mentioned the following:

'The necessary conditions for a bubble to form are quite simple, and number only two,' he said in his letter. 'First, the fundamental economic conditions must look at least excellent - and near perfect is better. Second, liquidity must be generous in quantity and price: it must be easy and cheap to leverage. If these two conditions have ever been present without causing a bubble, it has escaped our attention.'

Asset prices have soared in value everywhere in the world since October 2002. Prices of stocks, commodities, real estate, art and every kind of useless collectible have shot up. Even bond prices have until recently gone up as interest rates fell.

That all asset classes increased in value simultaneously around the world is most unusual.

Previous asset bubbles were concentrated in just one or a few classes: in the 19th century, canal and railway shares; in 1929, US equities; in the late 1970s, conglomerates; in 1980, gold, silver and oil; in 1989, Japan and Taiwan; in 2000, the telecoms, media and technology sectors.

The beauty today is that every kind of asset is grossly inflated. How could this happen?

Already ahead of 2000, the US Federal Reserve pursued an ultra-expansionary monetary policy. Then, after the March 2000 peak in the Nasdaq, the Fed eased monetary conditions massively. All asset prices soared, particularly for US homes. A subsequent boom in refinancing and home equity extraction injected an overdose of adrenalin into consumption-addicted US households. Thus, the US trade and current account deficit soared from less than $200bn in 1998 to above $800bn.

In turn, the US current account deficit provided the world with the so-called excess liquidity, pushing up international reserves and the prices of assets ranging from Warhol paintings to rare violins.

However, two asset classes stand out as big losers: the Zimbabwe dollar and the US dollar.The latter has been in a downtrend since 2001. Its value depends on the worst possible combination of factors: arrogant, bold and ignorant neo-conservatives; and Ben Bernanke, who prides himself by exclaiming that "we have the printing presses".

Luckily, Robert Mugabe has reminded the world that the more money a government prints, the weaker its currency and the higher its inflation and interest rates will climb.

Rather than travel to Beijing to lecture the very well-educated Chinese who in recent years have accumulated foreign exchange reserves of over $1,200bn, Mr Bernanke and Hank Paulson would have found it more productive to spend a few days in Harare, where they could have studied the devastating consequences of excessive money and credit.

In fact, we have already reached the danger zone. It is no longer the real economy that is driving asset prices.

In a credit, and hence asset price-driven economy, money supply and credit must continue to grow at an accelerating rate in order to sustain the expansion.

Money supply and credit suspension must continue!

Then the subprime mess came really messy and nasty and simply put a huge spanner to liquidity!

Here is an excert of an extremely imformative article posted on RealEstateJournal.com. ( here )

Today that market is a mess. As defaults have increased, investors who bought bonds and other securities based on the mortgages have found their securities losing value, or in some cases difficult to value at all. Some hedge funds that feasted on the securities imploded, and investors as far away as Germany and Australia have suffered. Central banks have felt obliged to jump in to calm turmoil in the credit markets.

It was lenders that made the lenient loans, it was home buyers who sought out easy mortgages, and it was Wall Street underwriters that turned them into securities....

Aug 14th 2007, the folowing article was posted by Fortune on CNN.Money, Is the worst over?

Here's a 10-point guide to what we know and don't know about the troubles, and what the repercussions are likely to be:

Why did America's subprime mortgage woes have such a big impact on world financial markets?

Because these mortgages were lumped together in packages and sold as asset-backed securities all over the world, particularly in Europe. Often the initial securities were themselves put into new packages, leveraged up and resold as so-called collateralized debt obligations (CDOs). They are a sort of derivative play on the underlying mortgages, just as futures and options are a play on stocks and commodities. Big banks have whole securitization departments who create these instruments. They do so to profit from the difference between the long-term returns these investment vehicles produce and their more plain vanilla short-term borrowing, and to earn fees.

Who bought them?

Everyone, and that's the problem. The CDO market has exploded in recent years: More than $100 billion worth of structured cash CDOs were issued in the fourth quarter of last year alone, according to CreditFlux Data+, a London firm that tracks them (and that doesn't include the even more arcane "synthetic" CDOs). Banks, institutional investors and hedge funds have been the main customers, but some retail investors have also bought into them through the asset-backed securities, or ABS, funds that some of the biggest European banks sell to the public. Everyone who bought these securities was given the same pitch, namely that they were a relatively safe bet, since much of the paper had AAA ratings, but offered higher returns than regular corporate bonds.

So what went wrong?

The number of delinquencies in the U.S. subprime mortgage market has been rising and is now substantially larger than anyone expected - about 14 percent of the total, up from about 10 percent in 2004 and 2005. That means there's a strong likelihood that some of the securities holders, especially those where the underlying mortgages were taken out in the past couple of years, are sitting on losses.

Those troubles have been massively compounded by the aggressive use of leverage in CDO packages. When U.S. blue chip financial players like Bear Stearns and then a variety of European banks began reporting problems, panic quickly gripped the markets. That turned into a vicious circle: These debt instruments have now become impossible to price because nobody wants to buy them any longer. And since they can't be priced, the size of the losses aren't clear, which in turn has given rise to more rumors about financial players in trouble. Banks in continental Europe especially simply stopped lending to one another, which is why the liquidity dried up in the credit markets as a whole and the European Central Bank had to jump in.

How big is the problem, really?

Nobody is quite sure. Patrick Artus, an economist at Natixis in Paris, reckons the total damage inflicted by subprime woes is a relatively manageable $45 billion, which is the difference between the expected rate of mortgage delinquencies and the current much higher rate. Another French bank that is an important player in the derivatives market, Sociéte Générale, reckons that even if things really turn sour, the worst will be losses of about $100 billion. That may sound like a lot, but it's the equivalent of about 1 percent of the total market capitalization of the S&P 500.

Such calculations highlight the real issue here, that the panic has been due more to a collapse of confidence than to any financial cataclysm. "We're still primarily looking at a liquidity crisis rather than a credit or a solvency crisis," says Fitch's Rawcliffe.

Is it really over?

No. The market "remains very, very fragile," says a top executive at one of the leading European banks. Some confidence has been restored into the international banking system and its overnight lending patterns by the big injections of central-bank funds, but nobody has yet dared to start buying that subprime paper in any sizeable quantities. And because there's so little transparency about who is sitting on what size losses, the rumors continue to swirl.

Nouriel Roubini, an economics professor at New York University's Stern School of Business, who has long warned about the risk of financial contagion, reckons some other parts of the U.S. housing market including home equity loans and second mortgages are starting to display what he calls the same "toxic characteristics" as the subprime sector. More optimistically, Neil McLeish, the chief European credit strategist at Morgan Stanley, says that, "we have passed the absolute peak of that anxiety and uncertainty." But even he believes that credit market conditions will be more difficult in the coming months and, "there is still some risk of additional volatility" at least for the next month or so.

Who are the biggest casualties?

Banks and financial market players across the world are starting to come clean about their exposure and losses, partly in order to help restore confidence in the market. The losses incurred by Wall Street titans Bear Stearns (Charts, Fortune 500) and Goldman Sachs (Charts, Fortune 500), which this week announced it is putting $2 billion into one of its hedge funds, have received the most publicity. Outside the United States, firms such as insurer AXA (Charts) and BNP Paribas in France have frozen or shut problem funds, while a range of banks including NIBC of the Netherlands and Commerzbank in Germany have detailed their exposure and expected losses.

The biggest international victim to date is a mid-sized German bank called IKB Deutsche Industriebank that its peers, including a government-owned bank, stepped in to rescue earlier this month, taking over $11 billion of credit lines and putting up a $4.7 billion funding package. IKB had been an aggressive player in the CDO market, through two off-balance sheet firms that it used to pump up its commission income and advisory fees. In the end, its exposure to dodgy securities through these two firms far exceeded the bank's liquidity and equity capital.

Is anyone safe?

Not completely, but barring some huge problem nobody yet knows about, major banks seem in the best position to weather this storm because they have the strongest balance sheets and are able to refinance their operations most easily thanks to the extra liquidity that central banks have put into the market in the past week. "Being a bank and having access to the central bank (credit) windows is key at the moment," says the top European banker.

Hedge funds are another story, as the Goldman Sachs-run one that was bailed out this week shows, although some of these funds foresaw the troubles and have been aggressively shorting the subprime sector and any securities relating to it.

Why didn't central banks cut interest rates in response?

Some critics of the European Central Bank, especially in France, are saying that its interest rate policy, which has consisted of regular rate hikes to counteract inflation, has partly fueled this crisis. "One can ask if the ECB isn't becoming a prisoner of its rate-increase strategy," Thierry Breton, the former French finance minister said this week. But bank economists are generally more supportive and say that the ECB acted smartly with its three consecutive days of huge money-market interventions - the biggest of which was a whopping $130 billion injection last Thursday. "It's a demonstration of the financial system operating as it should," said James Nixon, a London-based economist at France's Société Générale, who says that the troubles primarily affect the financial sector rather than the wider economy.

While the Fed did cut rates in 1998 during the last derivatives meltdown, involving Long Term Capital Management, central banks may not need to this time if markets continue to calm down. Indeed, the big question now is whether the ECB and the Bank of Japan will go ahead and raise rates in the next month, as they had signaled before the crisis. Roubini isn't sure, and thinks that the Fed may well move to reduce U.S. rates quite soon. "The likelihood of a cut in rates is now much higher," he says.

What does this mean for the world economy?

So far, not all that much - but keep your fingers crossed. Growth in Europe and Asia remains buoyant, even if the U.S. outlook is unclear. Some borrowing by companies and individuals is bound to get more expensive as markets adjust and restore a risk premium. But "it's not obvious that the repricing will lead to an economic slowdown," says Société Générale's Nixon, although there's a possibility that Britain's economy, which has thrived because of its heavy dependence on financial services, may be vulnerable. Roubini thinks the United States will bear the brunt of what he sees as an inevitable slowdown of consumer spending related to the housing woes, and reckons that this could ultimately spill over to the global economy if it's sufficiently severe. "The effect on the real economy in the rest of the world depends on whether there's a hard landing in the U.S." he says.

Will there be any regulatory fall out?

This is almost inevitable, especially in Europe where it's now clear that many of the purchasers of these securities didn't fully appreciate the risks they were taking. Look for the first moves to come in Germany, where bank bail-outs are exceedingly rare. The last time a bank got into serious trouble there was in 1974, when the Herstatt Bank collapsed after some disastrous forays into foreign-exchange trading that bear some similarity to IKB's woes. Regulators quickly followed up with an overhaul of the national banking system. It's not clear that IKB's rescue will have the same dramatic repercussions, but it's already prompting tough questions about how a mid-sized bank could end up with such an enormous exposure to risky assets via an off-balance-sheet firm.

"I suspect that at the end of this, regulators will ask themselves if this very rapid expansion (of transactions involving asset-backed securities) has been a good thing for banks, or if the risk comes back to haunt you," says Fitch's Rawcliffe. Watch also for credit agencies to come under pressure to do a better job at assessing the market risk of exotic financial instruments

...Then the Plunge Protection Team (aka the Federal Reserve) went to work and lowered the discount rate by 50 basis points. That gave the market a quick boost and certainly hurt a lot of bears. It’s interesting to note though that the indices generally closed below their opening levels. So there was no follow-through buying after the pre-market pop… not even panic buying from surprised bears. Options expiration probably played some part in Friday’s action as well. It’ll be interesting to see whether we get any follow-through next week.

And here are some interesting articles.

Behind the Financial Crisis: Info FailureMarkets can't work when lenders don't know what collateral is worth

The hardest thing to come by in the current financial crisis isn't money—it's reliable information. The lack of information—specifically, hard information about what assets are really worth—explains why prices in some markets are gyrating so wildly, and why trading in other markets has virtually ground to a halt.

The Federal Reserve is doing its best to restore confidence—most notably by cutting the discount rate by half a percent to 5.75% on Aug. 17 (see BusinessWeek.com, 8/17/07, "Fed Move Lifts Stocks").

But the Fed is running up against a big obstacle: If you don't trust the value of an asset, you won't be willing to buy it no matter how cheap your borrowing costs are. In an Aug. 17 commentary, Merrill Lynch (MER) economist David Rosenberg wrote: "Financial institutions, in general, are paralyzed by the lack of information [about asset values].… What brings this to an end, ultimately, is better information and transparency." click here for rest of the article

Fed Panics: Set-Up for the Next Leg Down?Although the initial reaction is one of euphoria, today's surprise discount rate cut by the Federal Reserve may have unintended consequences. In fact, it will likey be the trigger for the next leg down in the unfolding bear market.

For one thing, the move suggests that policymakers are worried -- really worried -- about the state of the economy, despite repeated assertions to the contrary. That is likely to force a rethink by nervous bulls in corporate America and elsewhere who have reluctantly accepted the party line that all is well.

The abrupt shift in stance, following meeting after meeting where policymakers expressed concerns over the pace of inflation, may also signal that thinking has become muddled at the Fed. Or that monetary policy is now in the hands of investment bankers and hedge funds. Some might even start wondering whether Bernanke & Co. have lost their way, at least in the near term. Not exactly a reason for optimism at a time when credit markets are under siege and risk is being dramatically repriced.

Clearly, the bears were caught off guard by the surprise cut. However, while a burst of short-covering and speculative buying can heighten the drama and paint a picture of benevolent central bankers riding to the rescue, it will also add to confusion about where policymakers stand. What happened to the new, more transparent Fed? Worse still, is this a sign that we returning to the bad old bubble-blowing days of the Greenspan era?

Finally, although equity markets have been under a great deal of pressure lately, the S&P 500 index is still basically up on the year. What’s more, the latest reading on gross domestic product signaled to many that U.S. growth remained on track. The big risk in shooting off a round of monetary bullets this early in the game is that the effect doesn’t last very long. In that case, the mood is likely to be even uglier during the next round of liquidation and deleveraging.

All in all, today’s move, while positive for sentiment in the short run, is unlikely to represent anything more than a temporary shot of adrenalin for wounded markets. Once the injection wears off, the bearish disease will likely be back in force.

What is so unusual about the current times that so many smart people could be so catastrophically wrong?

Porter comment: What happened (and what is still happening) is simply leverage in reverse, or what people used to call a "run on the bank."

For nearly 10 years, as interest rates fell from 1995 to 2005, the mortgage and housing business boomed as more and more capital found its way into housing. With lower rates, more people could afford to buy houses. That was good. Unfortunately, it didn't take long for some people to figure out that with rates so low, they could buy more than one. Or even nine or 10. As more money made its way into housing, prices for real estate went up – 20% a year for several years in some places. The higher prices created more equity... that could then be used as collateral for still more debt. This is what leads to a bubble.

Banks, hedge funds, and insurance companies were happy to fund the madness because they believed new "financial engineering" could take lower-quality home loans (like the kind with zero down payment) and transform these very risky loans, made at the top of the market, into AAA-rated securities. Let me go into some detail about how this worked.

Wall Street's biggest banks (Goldman Sachs, Lehman Bros., Bear Stearns) would buy, say, $500 million worth of low-quality mortgages, underwritten by a mortgage broker, like NovaStar Financial. The individual mortgages – thousands of them at a time – were organized by type and geographic location into a new security, called a residential mortgage-backed security (RMBS).

Unlike a regular bond, whose coupon is paid by a single corporation and organized by maturity date, RMBS securities were organized into risk levels, or "tranches." Thousands of homeowners paid the interest and principal for each tranche. Rating agencies (like Moody's) and other financial analysts, believed these large bundles of mortgages would be safer to own because the obligation was spread among thousands of separate borrowers and organized into different risk categories that, in theory, would protect the buyers. For example, the broker (like NovaStar) that originated the mortgages would be on the hook for any early defaults, which typically only occurred in fraudulently written mortgages. After that risk padding, the next 3%-5% of the defaults would be taken out of the "equity slice" of the RMBS.

The "equity slice" was the riskiest part of the RMBS. It was typically sold at a wide discount to the total value of the loans in this category, meaning that if defaults were less than expected, the buyer of this part of the package could make a capital gain in addition to a very high yield. Even if defaults were average, the buyer would still earn a nice yield.

Hedge funds loved this kind of security because the yield on it would cover the interest on the money the fund would borrow to buy it. Hedge funds could make double-digit capital gains annually, cost-free and risk-free... or so they thought. As long as home prices kept rising and interest rates kept falling, almost every RMBS was safe. Even if a buyer got into trouble, he could still sell his home for more than he paid or find a way to restructure the debt. On the way up, from 1995-2005, there were very few defaults. Everyone made money, which attracted still more money into the market.

After the equity tranche, typically one or two more risk levels offered higher yields at a lower-than-AAA rating. After those few, thin slices, the vast majority of the RMBS – usually 92% of the loan package – would be rated AAA. With an AAA rating, banks, brokerage firms, and insurance companies could own these mortgages – even the exotic mortgages with changing interest rates or no down payments. With the magic of financial engineering and by ordering the perceived risk, financial firms from all over the world could fill their balance sheets with higher-yielding mortgage debt that would pass muster with the regulators charged with making sure they held only the safest assets in reserve.

For a long time, this arrangement worked well for everyone. Wall Street's banks made a fortune packaging these securities. They even added more layers of packaging – creating CDOs (collateralized debt obligation) and ABSs (asset-backed security) – which are like mutual funds that hold RMBS.

Buyers of these securities did well, too. Hedge funds made what looked like risk-free profits in the equity tranche for years and years.

Insurance companies, banks, and brokers were able to earn higher returns on assets by buying RMBS, CDOs, or ABSs instead of Treasury bonds or AAA-rated corporate debt. And because the collateral was considered AAA, financial institutions of all stripes were able to increase the size of their balance sheets by continuing to borrow against their RMBS inventory. This, in turn, supplied still more money to the mortgage market, which kept the mortgage brokers busy. Remember all the TV ads to refinance your mortgage and the teaser rate loans?

The cycle kept going – more mortgage securities, more leverage, more loans, more housing – until one day the marginal borrower blinked. We'll never know whom or why... but somewhere out there, the "greater fool" failed to close on that next home or condo. Beginning in about the summer of 2005, the momentum began to slow... and then slowly... imperceptibly... it began to shift.

All the things the cycle had going for it from 1995 to 2005 began to turn the other way. Leverage, in reverse, is devastating.

The first sign of trouble was an unexpectedly high default rate in subprime mortgages. Beginning in early 2007, studies of 20-month-old subprime mortgages showed a default rate greater than 5%, much higher than expected. According to Countrywide Mortgage, the default rates on the riskiest loans made in 2005 and 2006 are expected to grow to as high as 20% – a new all-time record. The big jump in subprime defaults led to the first hedge-fund blowups, such as the May 2007 shutdown of Dillon Reed Capital Management, which lost $150 million in subprime investments in the first quarter of 2007.

Since Dillon Reed Capital, dozens of more funds have blown up as the "equity slice" in mortgage securities collapsed. Remember, these equity tranches were supposed to be the "speed bumps" that protected the rest of the buyers. With the safety net of the equity tranche removed, these huge securities will have to be downgraded by the rating agencies. For example, on July 10, Moody's and Standard and Poor's downgraded $12 billion of subprime-backed securities. On August 7, the same agencies warned that another $1 billion of "Alt-A" mortgage securities would also likely be downgraded.

Now... these downgrades and hedge-fund liquidations have hugely important consequences. Why? Because as hedge funds have to liquidate, they must sell their RMBSs, CDOs, and ABSs. This pushes prices for these securities down, which results in margin calls on other hedge funds that own the same troubled instruments. That, in turn, pushes them to sell, too.

Very quickly the "liquidity" – the amount of willing buyers for these types of mortgage-backed securities – disappeared. There are literally no bids for much of this paper. That's why the subprime mortgage brokers – the Novastars and Fremonts – went out of business so quickly. Not only did they take a huge hit paying off the early defaults of their 2005 and 2006 mortgages, but the loans they held on their books were marked down, with no buyers available and their creditors demanding greater margin cover on their lines of credit... poof... The assets they owned were marked down, they couldn't be readily sold, and they had no access to additional capital.

The failure of the subprime-mortgage structure – which started with higher-than-expected defaults, led to hedge fund wipeouts, and then to mortgage broker bankruptcies – might have been contained to only the subprime segment of the market. But... the risk spread because of the financial engineering.

With Wall Street wrapping together thousands of mortgages from different underwriters, it's likely that hundreds of financial institutions around the world have traces of bad subprime and Alt-A mortgage debt on their books. Parts of these CDOs were rated AAA. Almost any financial institution could own them – especially hedge funds. Hedge fund investors quickly figured this out – and asked for their money back.

And so, in July, liquidity fears began to creep through the entire mortgage complex. Not because the mortgages themselves were all bad or even because the mortgage securities were all bad – but because all the market players knew a wave of selling, led by hedge funds, was on the way. Nobody wants to be the first buyer when they know thousands of sellers are lined up behind them.

The market "locked up." Nobody would buy mortgage bonds. And everyone needed to sell. Suddenly even Wall Street's biggest banks – the very firms that created these mortgage securities – were suffering huge losses, as the bonds kept getting marked down as hedge funds and other leveraged speculators had to sell into a panicked market.

It's a classic "run on the bank," except today the function of the traditional bank has been spread out among several institutions: mortgage brokers, Wall Street security firms, hedge-fund investors, and banks. The real problem is that the long-dated liabilities (a 30-year mortgage) were matched not by reliable depositors, but by fly-by-night hedge funds, which were themselves highly leveraged and subject to redemptions.

That's why even as the top executives in these firms believed their mortgages were safe and sound, they can't get the funding they need to hold onto them through the crisis. As Keynes predicted, the lives of every higher-leveraged financial institution is precarious: " The market can be irrational longer than you can remain solvent."

The hedge funds have no solution. Redemptions will force them to sell. They'll continue to pressure the market, resulting in huge losses. Hundreds of funds will likely be liquidated.

Wall Street's investment firms, if they can find additional capital to meet margin calls, might weather the storm... depending on how far it spreads. We saw a move in this direction this week when Goldman announced $3 billion in additional funding for its big hedge funds.

For most mortgage brokers, the party is over – goodnight. Something like 90% of them will be out of business by the end of the year.

Saturday, August 18, 2007

Q: How do you read the events as they have unfolded in the past fortnight? How do you think this might shape up?

A: Basically as you know, the US market went up until July 16. The Dow peaked out on July 17 above 14,000 and then it started to slide, mainly driven by financial stocks and by what people call a crisis in the subprime lending sector and the CDO and the BS markets. The question obviously is where do we go from here? Is it like 1998, where we dropped first and then recovered strongly towards the end of the year or is it something more serious? I think it's something more serious.

Q: What’s your prognosis? You think this subprime situation will become worse or do you think these are just indicative of deeper problems in the US economy, which are manifesting themselves?

A: It’s a symptom of excessive credit growth that was obviously encouraged by the US Fed. They pursued extremely expansionary monitory policies before the year 2000, when they bailed out LTCM and then ahead of Y2K that boosted the NASDAQ between January and March 2000 another 30%. And then obviously by slashing the Fed fund rate from 6.5% to 1% and leaving it at 1% for an extended period of time and then as a Fed Chairman, also encouraging people to take out variable mortgages and applauding the subprime lending industry - that has to be said very clearly.

I think the Fed now has obviously stepped in. They bought mortgage-backed securities on last Friday. The ECB has also stepped in, but you create another problem by doing that. You don’t let the market kind of clear and so I suppose what we will eventually get, is more inflation and higher interest rates.

Q: You're saying that the Dow has reasonable chance of plunging below 13,000, or well below that?

A: We went up on the Dow in October 2002, when the Dow was around 7,600, to 14,000. This February in the correction we were at 12,000 on the Dow. The S&P has risen to a high of 1,555 on July 16. We are now down a 100-points.

I think it's not so much a question about how vulnerable the market is, but what is the upside potential. I think the upside potential is extremely limited and I would advise people to actually sell their shares on a rebound. We’re modestly oversold at the present times, some stocks are more oversold than others. Goldman Sachs is down 20% from its peak in a very brief period of time. So there will be bounces, but I would use the bounces as a selling opportunity and not think that this is just the correction in a rising market.

Q: If you did sell out, where would you park your money as there is some opinion suggesting that maybe in this seesaw, Asia and emerging markets will stand at the upper end, while the rest of the developed universe will probably struggle for a bit?

A: That I disagree with, because over the last 3-4 years, a lot of overseas foreign money has flowed into emerging economies and if you compare the performance of Dow Jones to that of the Indian market, then the Indian market is up five times since 2003. So lot of markets are very over extended. When you have a credit cycle of liquidity that turns down and this is a credit super cycle that now has run into some problems along with the process of de-leveraging.In such an environment you don’t what to be an emerging economy.

The outlook for the economies may be favourable, but the outlook for liquidity in emerging stock markets is not very favourable. Starting summer 2005, the housing stocks in the US start to break down and the optimist said don’t worry. Then starting summer of 2006, the subprime lenders started to break down and the optimist said don’t worry, it wont have an impact on the economy. This year, we have a break down of brokerage companies and financial stocks and it's like a domino effect that goes from one sector of the economy to another.

Q: So is it unlikely that equity markets from the emerging space will make new highs for themselves this year?

A: There is always the possibility that some market makes a new high. If I had to make a bet about the market that will make a new high, I would think that the gold market has a chance to make a new high. Because if the Fed cuts interest rates aggressively, in an extreme case, they would go from 5.25% on the Fed fund rate down to 3%. Then people will really become concerned about future inflation and the value of paper money and that will boost gold prices.

But right now my sense is that the best is to hold cash. Now the question is what kind of cash? People have been very negative about the dollar but I have noticed over the last two weeks, the dollar has actually began to perform better against the emerging market currencies - against the New Zealand dollar against the Australian dollar, it’s been weaker against the yen, but the US dollar is okay. Because if a foreign investor sells emerging stock markets, they convert the fund into US dollar and that should be supportive of the US dollar.

Q: You advised many hedge funds. Do you sense that the whole universe is running into a bit of trouble and hedge fund managers are looking to pare down exposure to emerging markets?

A: During the period 2002 to 2006, we had an increase in leverage. To perform you just built up your positions, financed with credits and now we have the process of de-leveraging. In other words, positions are being cut by the proprietary trading departments of banks, by hedge funds and by the insurance industry. And don’t forget a lot of family offices have behaved like hedge funds, they have also huge leverage positions and the funds are funds anyway.

So in this environment there is a general contraction of outstanding debts, the credit contraction is not good for asset markets.

Q: If you had to predict - since your view is bearish, what percentage fall would you expect in emerging market equities over the next foreseeable period?

A: The S&P has a very good chance to decline by 20-30% and the emerging economy stock markets could drop by 40%. That may not mean that the bull market in emerging market is over for good, because in 1987 we had drops in Taiwan of 50% and then the market went up another four times, so you can have a big correction and still be in the bull market.

But if some one came to me and said what is the upside on the S&P? We had 1,452 where the high was 1,555. I would say the upside and the big resistance in the market is between 1,520 and 1,530 so the upside is limited. But what about the risk?

What I noticed is investors are far more concerned about missing the next leg in the bull market on the upside, than about the risk of losing a lot of money. And I think, gradually this will change and that would mean lower equity prices and also prices of other assets such as commodities can go down substantially and obviously home prices around the world.